On 2016's first day of trading, the CSI 300, an index of China’s biggest stocks, fell abruptly by 7%, triggering the use of newly established circuit breakers designed to temporarily halt trading until calm was restored. The Chinese markets continued to fall another 5% when the markets reopened 15 minutes later, triggering another circuit breaker and a complete suspension of trading for the day. The global markets responded with steep declines of their own, resulting in the worst first-week decline in the Dow Jones Industrial Average (DJIA) in decades. Analysts were quick to attribute the contagion to fears of a crashing Chinese economy, but later examination suggests that the quick intervention by the Chinese government actually exacerbated the panic by creating more uncertainty. The market has been the target of unrelenting intervention by the Chinese government for several years, which seems to make and change rules without regard for their consequences.
A Brief Background on China’s Stock Market Interventionism
The Chinese government does not hesitate to insert itself into the markets when they do not cooperate with its policies. Often accused of currency manipulation, it keeps a firm grip on the yuan to force its devaluation when it needs more capital inflow. The government has stepped in to the stock market numerous times to place trading rules and restrictions to stem the volatility it helped create. After exhorting its citizens to jump into the market, the Chinese stock markets increased sharply through mid-2015. The bubble burst in mid-June, sending the markets into a 40% tail spin that subsided after the government stepped in with huge stock purchases. The markets slid again in mid-August, forcing additional government measures. The government lowered transaction costs and loosened margin requirements to allay fears of margin defaults. From there, the Chinese stock markets surged again through December 2016.
The Shanghai market rallied from 2014 into 2015, doubling in value, but then collapsed and is trading 45 percent lower. Some companies are unable to obtain equity financing and are increasing their debt. Trade tensions with the United States and the Trump administration are exacerbating investor concerns with threats of additional tariffs on Chinese imports. The yuan is weaker, and the currency is losing value.
Government Bull Propaganda
The stock market surge from mid-2014 to mid-2015 was fueled by a government communication campaign designed to encourage citizens to invest in the market. For months on end, the government touted the strength of the Chinese economy and virtually promised investors it would do whatever necessary to keep Chinese companies strong. More than 38 million new investment accounts were opened in the two months leading up to the mid-June crash, and the market surged another 80%.
The stock market bubble was largely driven by a massive inflow of money from small investors who bought up stocks on huge margins. Many of these inexperienced investors were among the last to get into the surging market and the first to panic when it came crashing down. Unlike Western markets dominated by institutional investors, the Chinese stock market is dominated by small traders who account for the bulk of the trades. As has been the case since the inception of the Chinese stock markets in the 1990s, speculation rather than fundamentals has been the main driver of market surges leaving all investors vulnerable to the unpredictable quirks of herd mentality.
The Lock-Up Rule
In the summer of 2015 and during the steep market decline, the government instituted a six-month lock-up on shares held by major shareholders, corporate executives and directors who owned more than 5% of a company’s tradable stock. The rule was intended to prevent massive selling in declining markets. With the first wave of locked-up shares coming due in January 2016, just three days after the massive plunge, the Chinese stock markets were fearing the worst, triggering another steep decline. The Chinese government extended the lock-up until additional rules could be established. Nearly 4 billion shares were set to become tradable again when the lock-up expired. Even in mature stock markets, such as in the United States, the anticipation of expired share lock-ups has always created downward pressure on the market. In this case, with an immature market, the effects are much more prominent.
Banning of Short Selling
Regulators banned one-day short selling, which is a primary cause of stock market volatility, according to the Chinese government. Although this restriction stabilized stock prices for a while, it could have led to greater volatility since short sellers are the only investors who are buying during a stock market rout. Without them, there is nothing to slow the decline. It is likely that the short sellers' absence exacerbated the stock market plunge. Note that the U.S. stock market's biggest collapse occurred after the Securities and Exchange Commission (SEC) banned short selling.
Quick-Trigger Circuit Breakers
The most recent demonstration of government intervention was with halting of trading by newly installed circuit breakers. In addition to the two times the circuit breakers were triggered during the crisis, they were triggered again two days later leading regulators to suspend their use because they did not have the intended effect. Later, regulators admitted the mechanisms may have actually increased market volatility.
The Bottom Line
Some market analysts have applauded the Chinese government’s willingness to intervene as it probably did stem volatility for a while. However, the government's trial and error approach may also be creating more uncertainty, which is also a cause of market volatility. The government's actions have been compared to a casino owner who keeps changing the rules to favor the house. In this case, the government appears to be manipulating the rules to favor a bull market, although it has not worked, and has actually eroded the integrity of the system and cast doubt on the government’s ability to manage its financial affairs.